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Annuities and Retirement Satisfaction

They’re not just a reliable source of retirement income—one study says they may make you happier, too

By Randy Myers

After a lifetime spent advising others on personal finance, John Kosinski admits that he’d started feeling “smarter than the market.” Then stock prices plunged in 2008, trimming the value of his retirement portfolio by 30 percent. “Luckily it was on paper—I didn’t sell anything, and my portfolio recovered,” Kosinski recalls. “But I’m getting to the point where I’m going to retire in maybe five to 10 years, and I don’t want my portfolio exposed to that kind of risk again.”

Kosinski, president of The East End Financial Group, a retirement and financial planning firm in Riverhead, N.Y., decided to take a fresh look at annuities—specialized insurance contracts that can provide investors with a guaranteed stream of income for life. He wound up using a portion of his retirement savings to buy a variable deferred annuity, the type where the ultimate payout is linked to the performance of an underlying investment portfolio of the investor’s choosing. Like most variable annuities sold today, though, this one also came with a so-called “living benefit” rider offering an additional performance guarantee. This one promised that the value of Kosinski’s annuity, for purposes of calculating payouts, would increase at least 7 percent annually until he begins taking withdrawals.

The purchase was quite a turnabout for someone who, Kosinski concedes, was never a big believer in annuities. “I always thought they were too expensive,” he says. “Now I’ve got peace of mind. I know that when I turn my faucet on—when I start taking withdrawals—this annuity will provide me with a guaranteed sum of money year in and year out.”

Kosinski’s initial skepticism was hardly unique. Especially in the 1990s, when stock prices seemed to always go up anyway, the idea of paying for investment guarantees via variable annuities seemed wasteful to many investors. And fixed immediate annuities, in which investors exchange a lump sum for payouts that start right away, were viewed by some as a risky bet: if you bought the annuity and died shortly thereafter, the issuing insurance company got to keep your money. “Even today, there remains this old perception that there’s no liquidity in these products—that if you give your money to the insurance company and die, you won’t get anything back,” observes Eric Henderson, senior vice president, Individual Products and Solutions, for financial services firm Nationwide Financial.

In fact, Henderson notes, much has changed, and living benefits for variable annuities are just one example of the upgrades. (In addition to roll-up guarantees like the one Kosinski’s annuity features, another popular living benefit is the guaranteed withdrawal benefit, which ensures that investors will be able to withdraw a minimum percentage of their contract value for life, even if their actual account value falls to zero.) Fixed immediate annuities have been souped up, too, with riders that, for an extra cost, allow you to access your money if you need it, and allow your heirs to recoup your remaining account balance if you die early. Most annuities also offer optional cost-of-living-adjustment riders now to help retirees keep pace with inflation.

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Ironically, the skepticism around annuities runs counter to research showing what people value in retirement. In a 2003 study for the nonprofit RAND Corporation, Constantijn Panis, a principal with Advanced Analytical Consulting Group in Los Angeles, looked at the results of the University of Michigan’s Health and Retirement Study for the years 1992 through 2000. That study surveyed more than 12,000 Americans over the age of 50 on topics related to aging and finances, including the impact of having a guaranteed source of retirement income in the form of a traditional pension. It found that the more people could count on that guaranteed income, the more satisfied they were in retirement, and the less prone they were to depression.

Unfortunately, fewer and fewer Americans have recourse to pension income these days, which presents them with multiple challenges. “The biggest risks for securing retirement income are longevity risk and investment risk,” Panis notes. “In the old days, with traditional pensions, investment risk was absorbed by the employer, and longevity risk—the risk of outliving your money—was either borne by the employer or outsourced by the employer to an insurance company through the purchase of annuity contracts. With pensions no longer available to most people, they could shield themselves from these risks by annuitizing at least a portion of their assets.”

How much to put into an annuity will depend on individual circumstances, but a reasonable starting point is to figure out how much of your fixed living expenses will be covered by Social Security and any other guaranteed income that might be coming to you, such as pension income, and then cover the rest with an annuity.

Choosing the Right Annuity

To be sure, it can be difficult for investors to determine not only how much income they will need in retirement, but also which annuity will be most appropriate for their needs. Annuities are complex solutions to complex problems. Henderson recommends working with a financial advisor who understands the product, and focusing on an annuity’s outcomes rather than its internal mechanics.

“Think about purchasing a car,” he explains. “A car is pretty complicated too, but most of us don’t care because we focus on the outcomes we want. Will it get me to work and back? Does it have heated seats? Does it have a good suspension? I can do the same thing with an annuity. If I want $40,000 a year and need exposure to the stock market for growth, I can easily see if a specific annuity will give me that.”

Many consumers shopping for annuities today tend to favor variable annuities over fixed immediate annuities, partly because payout rates on the latter are highly dependent on interest rates, and interest rates are at historic lows. Consumers who nonetheless want the benefits of an immediate annuity may be able to soften the impact of today’s low rates, Henderson notes, by building a laddered portfolio of annuities: buy one this year, another next year, and so on. “That way, if rates go up, you get the benefit with your next purchase,” he says.

If you are buying a variable annuity, Henderson adds, consider doing so several years before retirement, especially if it offers a guaranteed minimum income benefit that promises to “roll up” your account value for payout purposes. That will let you enjoy several years of growth while protecting you from market downturns during the critical years just before retirement.

That argument made sense to Kosinski, and based on Panis’ research, it should make sense for a lot of other investors too.

Randy Myers is a freelance writer whose work has appeared in Barron's, CFO and other prominent business publications.